If you knew whether the economy was headed for an inflationary or a deflationary period, your chances of crafting a winning investment strategy would be dramatically improved.

The reality: No one knows. That leaves investors with two alternatives, according to former hedge fund manager Jean-Francois Tardif.

One is to guess right and the other is to hedge, says Tardif, who compiled a stellar track record during 2004-2009 as manager of Sprott Opportunities Hedge LP, before retiring wealthy in July 2009 at a youthful 40.

At the time of his departure from Sprott Asset Management in July 2009, the fund’s annualized five-year return of 21.3 per cent was the highest of any fund in Morningstar Canada’s retail database. Tardif spoke at a recent Alternative Investment Management Association panel discussion in Toronto, on the subject of how to hedge against stock market risk.

Inflation — rising prices — is the prevailing historical trend. That’s why stocks — which on the whole have above-inflation rates of earnings growth over time — will produce returns higher than inflation. In the long run, stocks have far outperformed the safe but much lower returns earned from cash and other short-term instruments.

Though stocks are high on Tardif’s list of inflation-beaters, caution is in order. He believes the equity markets face more adversity than they did in the 1980s and 1990s. He cites the huge U.S. government deficit, sovereign debt problems in Europe, and central banks in the U.S., Europe and Asia seeking to stimulate their economies by printing money.

Tardif’s advice: avoid leverage, don’t concentrate your money in too few types of assets, and be opportunistic rather than simply buying and holding.

Making the right tactical moves is easier said than done.

But what applies to both active traders and buy-and-hold investors is the benefits of diversification: some asset classes tend to do better in inflationary times, while others do well when prices are falling.

Among the stocks that Tardif particularly likes are those of the world’s emerging markets in Asia, Latin America, eastern Europe and Africa. His other favourite inflation-beaters are commodities, gold bullion and farmland.

While inflation is more common, the economy will also undergo periods of weakness, accompanied by falling prices. In the financial markets, the fixed payouts of bonds become more valuable because their purchasing power is going up.

Tardif’s fixed income recommendations in a deflationary scenario include long-dated bonds of corporations and governments with high credit ratings. He cites Canada, Germany and Australia as examples of high-quality government issuers.

Stocks also have a place in a deflation-resistant portfolio, according to Tardif, provided that they are in recession-resistant industries.

For sophisticated investors only, there’s also short-selling. This is the sale of stocks you don’t own, with the aim of later buying an equal number of shares at a lower price to close out your short position. But if the stock instead goes up, your potential losses are theoretically unlimited.

Hedge funds that are designed to produce positive absolute returns, regardless of what the markets are doing, can also be part of the mix. There are no guarantees that hedging strategies will work, and returns are highly dependent on the skills of the fund managers.

Gold has historically served as a store of value in all kinds of markets, so it also makes Tardif’s list of what to hold in a deflationary environment.

The other asset class that makes both of his lists — though not as easy to buy as financial assets or bullion — is farmland. Why? Tardif’s succinct explanation: “Everyone’s got to eat.”

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